5 Steps to Make an All-Weather Portfolio

Investment tips that are good through bull and bear markets

If you did nothing but look at the Dow Jones Industrial Average at year-end 2010 (11,577) compared to the end of 2011 (12,217), you might say investors made little progress.

Click to Enlarge But you would be wrong! Just look at the chart to the right and you can see that the year-end comparisons are not reflective of the market’s actual behavior. Instead, the volatility of the marketplace offered some great opportunities to investors who were prepared to take advantage to buy low and sell high!

However, investors who merely “stayed the course” had a wild ride, and those who didn’t adequately protect their portfolios probably ended the year in the red. They made the same mistakes that many investors make: They love to buy stocks, and they hate to sell them. When the market looks enticing, they become so excited that they begin to buy stocks willy-nilly, with no thought to a balanced portfolio. And when the market drops, they become frozen, not knowing whether they should continue to buy more, to take advantage of the lower prices or just bail out and sell everything. And the sad result is usually this: When under pressure, investors generally make exactly the wrong decision!

In essence, they fail to plan.

But you don’t have to make the same mistakes. Instead, with a little thought and planning, you can create an all-weather portfolio.

Now, I’m not saying you won’t ever lose money, because there are no guarantees in the stock market. But there are steps you can take to minimize your losses and also maximize your profits.

Set a price target the day you purchase your stocks. Your target should be based on the P/E of your stock, multiplied out by expected future earnings. I’ll give you exact details on how to do this in a future article, but for now, I recommend you at least think about what price your stock can achieve within 18 to 24 months. And that should at least be a 30% to 50% gain. If it doesn’t have that potential, keep looking.

Going forward, when the stock hits your target, re-evaluate it and determine if it has the ability to continue double-digit price gains or if you would gain more by cashing in now and using those funds to purchase a different stock with more potential. My advice: Even if the stock still has some oomph left, I like to cash in one-half of my holdings, and let the remaining half ride toward my new target. (Read more about price targets here.)

Set a stop-loss limit the day you purchase your stocks. For aggressive investors, the stop-loss could be 30% or more. For more conservative investors, you might be happier with a stop-loss of 10%. I’ll also give you more details on setting stop losses later this week. The actual percentage is not as important as being disciplined in exercising the stop losses. Sure, no one likes to lose money, but a stock riding momentum down can clean you out in no time, so it’s best to take your losses. If the stock bounces back, you can always buy back into it. (Read more about stop-losses here.)

Diversify your portfolio to reduce your overall portfolio risk, as well as volatility. That means creating a portfolio with non-correlating assets, which, theoretically, results in assets that react differently to market catalysts. When market action causes some of your assets to decline in value, others should rise, effectively providing protection against your entire portfolio declining at the same time.

Consequently, you should own small-, mid- and large-cap stocks; companies in different sectors; and value and growth stocks. You also should have exposure to international stocks, either through owning multinational companies or via exchange-traded funds. And don’t forget about fixed income investments. As I said in my article last week, fixed income was the place to be in 2011. Some investors also might want to add currencies, commodities and real estate to their portfolios.

Put some dividend-paying stocks in your portfolio. They are a great hedge against inflation and provide terrific portfolio gains in down market cycles. Years ago, during the tech boom, I began adding dividend stocks, such as regional banks and Real Estate Investment Trusts, to my portfolio. The payoff was great! When the tech stocks hit the dust and the market took a downturn, I still was earning some great returns on my dividend stocks. Many investors neglect these companies as they think they are too boring. But what’s boring about making money? (Read more about dividend-paying stocks here.)

Consider buying put options as insurance that any unrealized gains you have don’t turn into losses. These options provide protection by betting that the underlying stock will decline. They give you the right (not the obligation) to sell the stock at a certain price at a specific future time.

Most investors don’t use options because they can be expensive and complex and have a reputation as risky. As well, employing options requires a pretty active style of portfolio management that many investors do not want to undertake. But simple options can help protect your portfolio on the downside and also improve your returns in a bull market. (Read more about put options here.)

There are additional methods for portfolio protection, including trading the VIX, a volatility index, which trades at a low price in steady markets and increases in value in volatile times. And as I discussed in my recent ETF articles, leveraged ETFs also have found a spot in portfolios in which investors are seeking protection against downside risk. However, I think both of these protections are best left for more experienced, sophisticated investors who are willing to be very active managers of their portfolios.

For most investors, following the above steps will help you create a portfolio that will thrive through normal up-and-down market cycles. While an undiversified portfolio can give you tremendous gains — if you are lucky enough to choose only “home-run” stocks — the plain truth is that most investors, individual or professional, don’t have a crystal ball. And stocking your portfolio with just one type of company or sector — no matter how promising — is a recipe for failure in the long term. So, do yourself a favor and take advantage of the tools that are available. And with technology today, it’s never been easier to take command of your investments.